How to compare mutual funds using Risk-adjusted returns

Here’s How to compare mutual funds based on Risk-adjusted returns:

How to compare mutual funds based on Risk-adjusted returns

Still concerned only about mutual fund returns?

Think big!

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How about Risk-adjusted returns!

While short listing mutual funds, you tend to be skewed towards returns. Like every other investor, you may give too much preference to returns over other factors.

Undoubtedly, fund return is a major factor which tells a lot about a mutual fund. It shows the intrinsic worth of a scheme vis-à-vis others.

Returns are calculated by fund NAV. It indicates the increase or decrease in the fund NAV over the said period. Thus, by looking at returns, you may ascertain its relative market value compared to other schemes.

While estimating returns, the fund house includes the effect of a dividend and other incomes generated by the scheme. So, you may regard returns as divulging much information about the upside.

But there’s another side of the story as well!

It’s called the risk-factor or the downside of a mutual fund.

Risk refers to uncertainty regarding the outcome. When the actual result doesn’t conform to the expected outcome, you call it a risky situation.

You might be well aware that mutual fund investments involve risk. Based on the type of fund, the degree of risk may vary. In simple words, risk means when the fund returns don’t match your expectations.

The other thing which is relevant at this juncture is: risk-return tradeoff.

Risk-return tradeoff means that risk is incidental to return. Higher risk is followed by higher returns; and vice-verse.

As a rational investor, you would always want to maximize your return at a given level of risk. Conversely, you may demand similar returns at a lower risk.

In this scenario, only taking an investment call based on plain returns would be unjustified. You would be ignoring the risk aspect of the fund. Moreover, such an approach won’t be handy in complex situations.

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Risk-adjusted returns: A better approach

Suppose you are considering two funds: Fund A and Fund B. Fund A gives a higher return than Fund B over the same period. Obviously, you would prefer Fund A over Fund B. So easy, isn’t it?

Now consider yet another situation wherein both the funds are giving the same rate of return.

How are you going to decide now?

At this juncture, you need to refer to risk-adjusted returns.

In investment domain, the risk is reflected in the Standard Deviation of a fund.

Let’s assume that fund A and fund B have a standard deviation of 12% and 15% respectively. It shows that fund B is riskier than fund A; which in turn implies that fund manager of B took higher risk than fund manager of B.

Going by the risk-return tradeoff principle, fund B should have given a higher return than fund A. But it failed to do so. Hence, you may conclude that fund A is a better performer than fund B.

You may regard such an approach as risk-adjusted returns approach. In this, you tried to find out how much money the fund made relative to the amount of risk it assumed over a given time interval.

Now you know that risk-based approach facilitates better decision-making over plain returns-based approach.

Using standard deviation to determine risk-adjusted returns is a very rudimentary approach. You may use even better methods to arrive at risk-adjusted returns.

The fact sheet of a fund enlists a range of financial ratios which is a robust way to ascertain risk-adjusted returns.

Financial Ratios: a glimpse into risk-adjusted returns

You may use these ratios to get a risk-based fund outlook:

How to compare mutual funds based on Risk-adjusted returns

Sharpe Ratio

It measures the excess return that the fund has generated per unit of additional risk assumed. It’s the most frequently used and standardized measure to determine overall risk-adjusted returns.

It is calculated by using the following formula:

Sharpe Ratio = (Portfolio return – Risk-free Return)/ Portfolio Standard Deviation

In this, you can see how much risk premium is available for every additional unit of volatility. A fund’s risk-adjusted return will rise only when it’s generated a higher excess return at higher volatility levels.

Standalone, Sharpe ratio conveys little sense. You need to look into other funds Sharpe ratio to draw meaning. Ideally, the fund with a higher Sharpe ratio is considered superior to the fund with lower Sharpe ratio.

Treynor Ratio

It measures extra returns that fund has generated for every additional unit of market risk assumed. Unlike Sharpe ratio, Treynor Ratio is relevant only in specific situations.

Treynor Ratio assumes that portfolio is well-diversified and thus, the investor should receive a premium for the additional risk-taking.

It is calculated by using the following formula:

Treynor Ratio = (Portfolio return – Risk-free Return)/ Beta

You can see that the denominator used in Treynor Ratio is different from Sharpe Ratio. Here, the beta has been used as an indicator of market risk.

The fund having higher Treynor Ratio is regarded superior over fund with a lower Treynor Ratio. It means that the former gives better compensation for extra risk-taking than the latter.

Sortino Ratio

Sortino Ratio is meant for you if you are more worried about the downside as compared to the upside. It calculates the excess return for every additional unit of downside volatility assumed.

Downside volatility relates to the standard deviation of only negative returns. In this, positive returns are not accounted for during computation of standard deviation.

It is calculated by using the following formula:

Sortino Ratio = (Portfolio return – Risk-free Return)/ Downside volatility

A fund with higher Sortino ratio is better than a fund with lower Sortino ratio. It means the former compensated better when the fund returns dipped below the average.

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Is high-risk taking fruitful every time?

Your risk-taking capacity is reflected in your risk appetite. It shows how much volatility in the fund value is acceptable towards goal-attainment.

You will not have the same risk appetite throughout. It keeps changing with your age and stage of the life cycle. It’s higher during the youth, and keeps diminishing as you grow older.

You need to use the risk-adjusted returns keeping your risk appetite in mind.

It has got several implications:

1. A fund giving higher risk-adjusted returns might not always be suitable; especially when the level of risk assumed by the fund is higher than your risk appetite.

2. A fund providing higher risk-adjusted return doesn’t mean that it won’t suffer losses. There is always a possibility that fund will lose more when markets turn bearish.

3. A fund giving higher risk-adjusted return isn’t always right. Suppose risk-adjusted returns of fund A and fund B are 7% and 8% respectively. On the face, fund B looks desirable. The standard deviation of fund A and fund B is 10% and 15% respectively.

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Also read: 5 surprising investing truths

So, the extra return given by fund B is just 1%. However, it’s 5% riskier than fund A. Hence; such excess return looks insignificant considering the risk that fund B assumes. It would be wiser to sacrifice the extra 1% return and go with fund A.

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